Estate Planning or Alphabet Soup?

Everyone talks about needing an estate plan, but they vary greatly in complexity based on each client’s circumstances. Trusts are a major part of most estate plans and attorneys and financial advisors love acronyms to describe the various types of trusts, but what do all these letters mean and what purposes do they serve? Consider the following trusts that are frequently mentioned in a comprehensive discussion about estate planning.

Revocable Trust: This is the basic trust prepared for most individuals and spouses. It is an alter ego of the individual, and while the individual is living uses the individual’s social security number. It is used to avoid probate, and the expense, delays and publicity associated with probate. Revocable trusts can also be used to avoid commingling separate property assets with marital property assets in the event of a future divorce.

Irrevocable Life Insurance Trust (ILIT): An ILIT is an irrevocable trust which holds life insurance as its principal asset. It is used to create liquidity, without any additional estate tax exposure, on the settlor-insured’s death. The insurance policy’s death benefit can either be loaned to the settlor’s estate, or used to purchase assets from the decedent’s estate, to pay estate debts, expenses, and taxes. While estate taxes have not been much of a concern since the 2017 Tax Act increased the applicable exemption amount and the advent of portability between spouses, federal estate taxes may become far more important in estate planning with the scheduled sunset of the large applicable exemption amount starting in 2026 which will be somewhere between $6.5-$7 million.

Crummey Trust: This trust is used to receive federal gift tax annual exclusion gifts ($17,000 per donee in 2023) without giving them directly to the beneficiary. The trustee sends the beneficiary a notice advising them of their “Crummey” withdrawal rights to the value of the gift. This process is often used to transfer funds into an ILIT to pay the life insurance premium obligation of the ILIT.

Qualified Terminal Interest Trust (QTIP): This is typically a type of marital trust for the benefit of the spouse which may be created after the death of a settlor of the revocable trust. It is used to financially provide for a spouse and requires that all trust net income be paid to the spouse-beneficiary. Assets in the QTIP trust are sheltered from the beneficiary-spouse’s creditors. The QTIP trust can also be set-up during the settlor’s lifetime to provide an income interest in the QTIP trust to the settlor after the beneficiary-spouse’s death. This variation also protects trust assets from the settlor’s creditors and allows the income tax basis in the trust assets to be ‘stepped-up’ to the value of the assets on the beneficiary-spouse’s death, thus avoiding capital gains tax.

Spousal Lifetime Access Trust (SLAT) or spousal lifetime access non-grantor trust (slant): This irrevocable trust is used to protect the settlor-spouse’s large applicable exemption amount ‘now’ before it is reduced in 2026. The settlor-spouse continues to have indirect access to the SLAT’s income and assets so long as their spouse remains the beneficiary of the SLAT. The assets in the SLAT avoid estate taxation on the beneficiary-spouse’s death and are protected from creditor claims.

Intentionally Defective Grantor Trust (IDGT): An intentionally defective grantor trust is one which is irrevocable and outside the settlor’s estate, but where the settlor continues to pay the income tax on the trust’s income. The trust usually permits the settlor to exchange assets in the trust. A common use of this trust is to move an appreciating asset (e.g. a business) out of the owner’s taxable estate without incurring a gift tax. The grantor sells the asset to the trust for a promissory note. The “sale” is not a gift, but because the sale is to a grantor trust, no capital gains are recognized by the settlor. The settlor’s payment of the trust’s income tax is not treated as a taxable gift by the settlor to the IDGT’s beneficiaries. The Department of Treasury recently issued a ruling that the assets in this type of trust will not receive stepped basis at the settlor’s death. The Department of Revenue does not like these structures and has proposed that the settlor’s payment of the income tax be deemed a gift and that the sale of the asset to the trust would be subject to capital gains.

Grantor Retained Annuity Trust (GRAT): This trust is a type of intentionally defective trust used to potentially shift appreciation in the trust’s assets to the trust’s remainder beneficiaries with little or no gift tax consequences to the settlor. The GRAT’s goal is to remove the appreciation from the settlor’s taxable estate. An appreciating asset is transferred to the GRAT and the settlor receives an annuity payment. At the end of the term, the assets transfer to the remainder beneficiaries. The GRAT works best if the assets in the trust grow faster than the deemed interest rate that is used to calculate the annuity that the GRAT pays to its settlor. The Department of Revenue has also proposed changes that would severely hamper the GRAT’s effectiveness.

Qualified Personal Residence Trust (QPRT): A QPRT is used to shift future appreciation in a principal residence out of the settlor’s taxable estate to the remainder beneficiaries with little gift tax consequences to the settlor, while still enabling the settlor to continue to use and enjoy the residence for a defined fixed period of time. During the QPRT term, the settlor pays all property taxes, insurance, and general maintenance expenses. An important note, if the settlor survives the QPRT period, the settlor will need to pay rent to the beneficiaries, typically the settlor’s children.

Charitable Remainder Annuity Trust (CRAT) or Charitable Remainder Unitrust (CRUT): These trusts are used to create an immediate income tax charitable deduction for the settlor while deferring capital gains on the trust’s sale of the appreciated contributed asset. The trust is tax exempt, so it does not pay a capital gain tax on its sale of its appreciated asset. The result is more assets remain inside the trust to be invested for the settlor’s benefit. In a CRAT, the settlor receives a specified amount. In a CRUT, the settlor receives a specified percentage. The remainder beneficiary of the trust is a charity, which can be selected by the settlor-trustee-life beneficiary. A Charitable Trust is normally used only if philanthropy is important to the settlor.

Charitable Lead Annuity Trust (CLAT): This charitable trust is used to shift taxable income away from the settlor to charities which are beneficiaries for a period of time (e.g. 20 years). At the end of the charitable annuity payment period, the trust assets are then either distributed to the settlor’s descendants, or they continue to be held in trust for the benefit of the settlor’s descendants. Like the CRAT and CRUT, only those settlors who are philanthropically inclined are good candidates for a CLAT.

For assistance in determining which serving of alphabet soup applies for you and your family, your client centric team will work with you, your accountants and attorneys, to suggest the best flavor.

Footnote: The terms grantor and settlor are interchangeable.